Liquidity suppliers and market makers profit by providing immediacy for less patient investors. In other words, the liquidity suppliers accommodate buying and selling pressure. However, they have limited capacity for carrying inventory and bearing risk. They are only willing to facilitate trading if they can buy shares at a discount or sell at a premium. This feature of markets has implications for asset price dynamics.

While researchers have previously tried to link liquidity and stock returns through such price reversals, Terence Hendershott and Mark Seasholes provide empirical evidence by directly measuring market maker inventories.

"By identifying and studying the inventories of traders who are central to the trading process and whose primary role is to provide liquidity - the NYSE market makers - over an 11-year period, we are able to contribute to a deeper understanding of inventory/asset price dynamics," they say.

"These liquidity suppliers will hold suboptimal portfolios only if they are compensated by favorable subsequent price movements." Consider a liquidity supplier who sees lots of selling pressure in the market. Prices typically fall when selling pressure is high. The liquidity supplier will buy shares (accommodate the sell orders) but it likely to end up with a larger-than optimal inventory. He can be compensated if future prices go up (i.e., if prices reverse the early fall.)

Using data on inventory and stock prices at daily and weekly horizons from 1994 through 2004, they find market maker inventories are negatively correlated with contemporaneous returns at both the aggregate market and individual stock levels. This finding is consistent with specialists acting as dealers and accommodating buying and selling pressure.

The authors also look at stock's future performance. To do this, the authors sort stocks into five portfolios based on current market-maker inventory levels. Portfolios of stocks with Portfolios comprised of low (negative) inventory stocks have next-day returns close to or below zero, while the portfolios of high-inventory stocks have returns between 8 basis points and 10 basis points the next day. Even over a longer horizon of 10 trading days, the highest inventory portfolio outperforms the lowest.

Overall, the authors confirm that market makers are compensated for inventory risk by a subsequent reversal in stock returns.